There are many approaches investors can take when building their portfolios. Two of those choices are futures contracts and Exchange Traded Funds, or ETFs.
Access Physical Markets
One major reason traders use these products is to gain access to physical markets, like gold or oil.
In the crude oil market, managed money customers usually do not own assets or engage in the underlying physical market to trade, store and deliver physical crude oil. Physical market participation requires significant infrastructure investment in oil production, storage tanks and pipeline distribution facilities. The same challenge applies to other physical markets as well.
To gain direct crude oil market exposure, investors can trade WTI futures contracts, which are physically-delivered light sweet crude oil from the Cushing, Oklahoma hub. WTI futures is the international benchmark for crude oil prices, increasingly so with U.S. production growth and the lift on the crude oil export ban.
Futures versus ETFs
Some advantages of futures over ETFs include:
No management fees
Roughly 24-hour trading access; when overnight market events, such as elections or weather, impact oil prices, there is no delay before you can trade – unlike waiting for ETF open.
Many oil or energy ETFs use futures to provide market exposure; whereas trading NYMEX WTI futures gives you direct access
When NYMEX WTI futures roll approaches, oil ETFs often lose some of their correlation to the underlying market, which can inflate your costs due to slippage.
The two popular crude oil ETFs are the United States 12 Month Oil Fund (USL) and the United States Oil Fund (USO). Both ETFs are issued by the United States Commodity Fund, LLC but represent a different underlying futures exposure.
The USO is designed to track the price movements of the WTI futures spot month contract. If the front month contract is within two weeks of expiration, the positions on the front month contract will be rolled over to the second front contract.
USO has different WTI exposure than the WTI front month futures contract because of its roll over schedule. Since the USO rolls over its front month contract two weeks before it expires, it is in fact exposing approximately half of its price exposure to the second front month contract price.
Historically, the USO performance deviates slightly from the WTI front month contracts. Even though the USO tries its best to mimic the front month WTI price, performance also deviates from WTI spot prices due to roll yield, transaction costs and management fees.
The USL is designed to track price movements of the rolling average of NYMEX WTI futures 12-month forward contracts.
The front month contract position is rolled over to the 12-month forward contracts, constantly maintaining an average price exposure of the rolling 12 consecutive months.
Investors need to be aware of the differences between futures and ETFs so they can decide what works best for them.
Peter Knight Advisor